These Specialty REITs Could Dominate in 2012

In 2011, while Europe was collapsing and Netflix was Qwikster-ing, the hotel industry was silently gaining momentum. But despite hotels' positive outlook, the market just doesn't seem to be paying much attention -- which makes this the perfect time for investors to get in. And while I love recognizable brands like Marriott and Intercontinental Hotels Group, my favorite way to invest in the hotel industry right now is through hotel real estate investment trusts, or REITs.

How hotel REITs workREITs can be kind of confusing, sometimes complex, and almost always intimidating for beginning investors. But hotel REITs are fairly straightforward. Boiled down, this is how they operate:

2. Pay somebody to manage those hotels: To qualify as REITs, the trusts are not allowed to operate the hotels they acquire, so they pay a management company to do it for them. They only pay the management company to run the hotel, though. The trust retains the actual revenue from the property.

3. Pay shareholders: All REITs (hotel and otherwise) are required to pay 90% of their profits to shareholders.

4. Keep the leftovers: With the remaining 10%, hotel REITs can pay down their debt or maybe even buy a few more hotels.

If you dig into it, a REIT's operations can get more complex. But for most investors, the above information is all you really need about what makes them tick.

Hotel REITs in 2011If you look at the chart below, you'll see that 2011 was not a great year for hotel REITs or their investors:

With the exception of Ashford at the beginning of the year, hotel REITs underperformed the S&P 500, and all realized somewhat significant losses by the close of the year.

This slump was tough for investors to stomach, because the hotel industry overall actually had a great year. Occupancy was up 2.6 percentage points to 60.1%, and average daily rates grew 3.7%. Because of that, the average revenue per available room increased 8.2% -- the highest jump hotels have seen since 2005. The industry's improvement hasn't been so apparent to the public, though, since most of the growth was fueled by increased business travel in gateway cities like New York City and D.C.

While great performance in the industry didn't mean great market performance for hotel REITs last year, I think 2012 will be different. Low short-term interest rates suggest a great year for all REITs, and hotel REITs shouldn't be an exception.

HotelREITs in 2012But even with the industry's recent and projected growth, hotels are still far from where they were five years ago. Those who haven't benefited from the recovery due to geography or demographics are still dealing with unprofitable properties.

Unfortunately for them, an estimated $9.1 billion of hotel commercial mortgage-backed securities (CMBS) debt will mature this year. Many of those loans were issued in 2007, when loaning money was a much less stringent process and assets were valued higher. That funding gap will make it difficult for unprofitable hotels to refinance.

Mass hotel foreclosures are unlikely since lenders won't want an unprofitable business on their hands. Since the majority of their funds will be tied up in refinancing, we will see very few new loans being written. This will mean less money for acquisitions. In response, many hotel REITs will likely sell properties from their existing portfolios to raise new capital.

No new loans will also mean less money for renovation and construction, which will have a surprisingly positive effect on the industry. If demand grows while supply stays the same, hoteliers get automatic pricing power, something that's been missing since the recession. Historically, raising rates has been the most sustainable way for hotels to boost profits (as opposed to simply increasing occupancy).

Those are some good-looking hotel REITsIn the chart above, I listed five REITs. All of these companies focus on acquiring hotels in gateway cities, so they are well positioned to benefit from continuing trends. Let's take a look at how a few of their numbers stack up, and then I'll tell you about my favorite, Pebblebrook:

Pebblebrook is a young trust, but it's shown a lot of energy with a smart and experienced management team since its inception in 2009. In fact, in January they were able to obtain a $46 million loan. With six acquisitions last year, they were the second most active hotel REIT out there. (Chesapeake Lodging came in first, with seven acquisitions, plus another one worth $76.5 million earlier this week.) Its relatively low debt burden should give it added flexibility navigating credit markets in the coming years.

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